ETFs have been in the news lately because some financial sales organizations have banned or limited their representatives’ use of special kinds. But what is an ETF anyway?
Let’s begin with Mutual Funds 101. Regular open-end mutual funds date back to the 1920s and feature professional managers trying to choose the best of class of stocks, bonds or other investments in order to outperform an index such as the S&P 500 or a broadly defined descriptor such as Balanced (stocks and bonds). You buy or sell them once a day based upon the closing price of all of the investments in the pool.
Examples of sponsoring companies would include American Century here in Kansas City or Fidelity in Boston. Almost all choices within 401(k) plans or variable annuities are forms of this type of managed fund.
Back in the late 1990s, when the S&P 500 index happened to fare so well that it enjoyed a record five consecutive years of 20-plus percent growth, conventional wisdom came to say, You shouldn’t invest in anything but a good index fund because even good fund managers cannot outperform them anyway in the longer term. These were not managed. You simply owned a piece of everything represented in the index, whether good or bad.
As information and trading moved at ever faster paces, investors wanted to be able to buy or sell a fund during the market day based upon what was happening. If a Black Monday comes along, why should one have to suffer the entire loss by selling at day’s end? Other fund critics wanted to be able to make diversified investments with lower expenses.
In response, financial firms began to manufacture and offer you the ability to buy shares that contained all of the components of an index that you buy or sell like a stock at any time of the trading day. Thus State Street created the most widely recognized fund that closely corresponds to the S&P 500 itself. The trading symbol is SPY and it has created its marketing theme for a whole host of its funds using the theme of Spyders (sic). The one for the Dow 30 Industrials is known as Diamonds because its symbol is DIA and the NASDAQ 100 has QQQQ for its symbol.
You might say the idea caught on. There are about 800 different mutual funds that now qualify as ETFs. In general their internal expenses are far less than regular managed funds, as low as one-tenth of 1 percent, because you do not pay for the brains to actively pick the components or to buy and sell them at different times.
The controversy arises over their use because some of them are the equivalent of a high-powered investment rifle. Not only can you buy them as a substitute for a particular index or sector, but you can leverage your results with some that will give you 100 to 200 percent more movement than the underlying components. Plus you can buy the inverse (or short) of the index or sector.
Therefore, if you thought a year ago that crude oil would fall in price and bought PowerShares DB Crude Oil Double Short ETN (DTO) about July 8, you would have a profit today of more than 220 percent. If you bet oil would continue to go up from $146 a barrel, you would have lost 82 percent on an opposite fund, DXO. Because of this volatility, some buy-and-hold broker-dealers have taken some or all ETF’s out of their representatives’ arsenals, including Edward Jones, LPL and Ameriprise.
I will bet some of you would like to have had any position in your portfolio that went up more than 100 percent while your regular stocks or funds were dropping like rocks. I understand caution, but I want all of the best tools available to make money and protect it from loss for our clients.